What is happening to Pandora – and why it is not enough

It has been a tough month for the NASDAQ, with tech stocks dropping and in particular for Pandora Media (P:US). For the first time since our first article, when we suggested to short sell the stock, our position is now profitable (+9,52%).
The downturn in techies is deepening and the spreading acknowledgement that the growth rates and multiples that investors were paying for tech stocks (and in particular, to web and mobile services) are far from reality, is causing a massive sell-off in this sector.
Even David Einhorn pointed out this new trend in his annual letter to shareholders.
For what concerns Pandora’s business, the lawsuit in which the company was involved along with ASCAP turned to be a half-victory, with the royalty rate that Pandora must pay left unchanged at 1.85 percent of the revenue; but just few days later, three major labels (Sony, Warner, and Universal) sued the company claiming that Pandora must pay royalties also for the songs recorded before 1972.
On the competitor side, Twitter announced it is refocusing its effort on music after the shutdown of Twitter Music and YouTube delayed its entrance in the market, while Apple is trying to reach an agreement with Beats Electronics, that launched a streaming service called Beats Music some months ago; user remains steady around 76 million (+8% YoY) while main competitors (Spotify, iHeartRadio and Itunes Radio) are growing faster.
Nevertheless, even a top-line beat on revenues in the last earnings announcement, did not convince investors on one of the first issue we pointed out on the company: profitability. Rising contents’ costs and marketing expenses are beginning to scare investors, and for the first time also the CEO admitted that those costs were necessary in order to expand (maintain?) the leadership position in the market.
Now that the share price is not completely irrational, we can at least start thinking about our “fair price” for the stock; that is why we analyzed the last five quarters (those of the great run-up in the stock price).
As pointed out many times, Pandora as a huge problem: the business model seems not to be sustainable at all. Even with a solid growth in revenue (helped by the increase of the subscription price), the costs of the advertising platforms and customers acquisition are growing faster; the main driver are the general costs, that include marketing expenses and general administrative costs (i.e. local advertising offices).
The chart below displays this issue (due to a change in their fiscal calendar, Q4 2013 and Q1 2013 overlapped, we did not included data for December 2013 due to this):

With rising costs, slower growth (turned from double digit in 2011 to single digit in 2013) and competitors eroding its leadership position, profitability looks still far: in a conservative scenario, with the revenue matching consensus and total costs growing at the weighted average growth rate of the 2011-2013 period, loss is expected to expand further:

The profitability issue is scaring investors, but the real point is that now (and not a year ago) investors are avoiding risky bets on high-growth frenzy stocks: in 2013, NASDAQ surged 29% and Pandora 167%, but Pandora was already showing huge problems in its business model, and per-user ratios help us making this clear:

Cost-per-User and Revenue-per-User were up in a similar way (but CPU is accelerating), but the Price-per-User outperformed both the Revenue growth (and we know that in the long term these should converge) and the User growth; the main driver were the expectations on revenue but now it is clear that as long as Pandora will have to increase spending in order to acquire (and maintain) customers the profit margin will not allow the company to reach profitability.
The irrational expectations that are (were) fueling Pandora seems even clearer if we take in consideration the Price/Sales ratio:

The Price/Sales of “Pandora 2011” (Users Growth: 50%) was way less than that of “Pandora 2013” (Users growth: 8%): investors were expecting revenue growth without knowing that a slowdown in viral growth would have pushed paid customers acquisition, marketing efforts and general costs increasing.
We expect a normalization of the Price/Sales ratio, that could at least match that of the beginning of the 2013: in that case, the price would be 16 USD, 30% less than the current price.
In the long term, investors could seriously reconsider the idea of investing in a company that won’t reach profitability: if the price will fall to reach an interesting valuation Pandora could become a target for an acquisition (rumors says Amazon would be interested). Other ways, the NASDAQ is full of unprofitable but stable (as Pandora is due to its good financials) companies that did not meet their initial expectations: Pandora may become one of those, maybe soon.

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